‘Governments that do not respect central bank independence will ignite economic fire and come to rue the day.’

Reserve Bank of India Deputy Governor Viral Acharya’s speech last week was seen by many as a clear indication of the friction between the government and the central bank, which has now properly spilled over into the public domain. On Wednesday, reports suggested that the government had floated the idea of invoking Section 7 of the RBI Act, which would allow it to give instructions to the central bank, albeit “in consultation with the Governor”. This section has never been invoked before, not even during India’s most trying economic crises. As a consequence, even the suggestion is a reflection of how bad Centre-RBI ties are.

There has even been talk of RBI Governor Urjit Patel tendering his resignation if, indeed, the government does invoke Section 7 and order the central bank to act a certain way. With this in mind, it is worth going back to Acharya’s speech, the AD Shroff Memorial Lecture, on October 27. The speech was taken as a symptom of the fight between the government and the RBI. But the specific warning within it goes beyond any current conditions and applies to any discussion about power struggles between governments and their central banks.

Acharya in fact began his speech invoking the experience of Argentina’s central bank chief in 2010, when he chose to resign from his post. Martin Redrado, the central banker, decided to go because the Argentine political leadership ordered the bank to transfer its reserve into the government’s kitty. This action, and Redrado’s resignation, led to a reassessment of Argentina’s sovereign risk, meaning the market made it much more expensive for the government to borrow money and ended up sparking a constitutional crisis.

“This complex interplay of the sovereign’s exercise of its powers, the central banker’s exit, and the market’s revolt, will be at the center of my remarks today on why it is important for a well-functioning economy to have an independent central bank, i.e., a central bank that is independent from the executive branch of the government. I will also try to lay out why the risks of undermining the central bank’s independence are potentially catastrophic, a “self-goal” of sorts, as it can trigger a crisis of confidence in capital markets that are tapped by governments (and others in the economy) to run their finances.”

Acharya’s speech is, as a result, remarkable in how well it lays out exactly what seems to be happening between the Centre and the RBI right now, especially with talk of Patel considering what Redrado did: resignation. The deputy governor even helpfully used a cricketing analogy to simplify the reasons that central banks and governments will always have different outlooks.

A government’s horizon of decision-making is rendered short, like the duration of a T20 match (to use a cricketing analogy), by several considerations. There are always upcoming elections of some sort – national, state, mid-term, etc. As elections approach, delivering on proclaimed manifestos of the past acquires urgency; where manifestos cannot be delivered upon, populist alternatives need to be arranged with immediacy. Less important in the present scenario, but only recently so, wars had to be waged, financed and won at all costs. This myopia or short-termism of governments is best summarized in history by Louis XV when he proclaimed “Apres moi, le deluge!” (After me, the flood!).

In contrast, a central bank plays a Test match, trying to win each session but importantly also survive it so as to have a chance to win the next session, and so on. In particular, the central bank is not directly subject to political time pressures and the induced neglect of the future; by virtue of being nominated rather than elected, central bankers have horizons of decision-making that tend to be longer than that of governments, spanning election cycles or war periods... Unsurprisingly, central banks strive to build credibility through a series of difficult choices that reflect sacrificing short-term gains for long-term outcomes such as price or financial stability.

The speech makes a fervent argument for why governments should shed the temptation for short-term action, or else face retribution from the markets and elsewhere.

Far-sighted government leaders may be able to reap benefits of convincing voters about the importance of investing in macro-economic stability; for instance, by claiming credit for the long-term nature of financial sector outcomes attained by allowing the central bank autonomy in decision-making and delivery of its core functions. When such a measured perspective of an independent central bank as a key element of durable economic prosperity is missing and/or government myopia so rife as to lead to regular inroads into central banking apparatus and decisions, unfortunate accidents can arise...

As this dynamic plays out, markets watch keenly, and if uncertainty grows and confidence in central bank independence and credibility erode, then markets rap bond yields and exchange rate on the knuckles!

Acharya saved his sharpest words for the very end though, effectively telling the Government of India what is going to happen if it tries to undermine the Reserve Bank of India.

As many parts of the world today await greater government respect for central bank independence, independent central bankers will remain undeterred. Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution; their wiser counterparts who invest in central bank independence will enjoy lower costs of borrowing, the love of international investors, and longer life spans.